Growth stocks have outperformed their value counterparts in all but three years since the financial crisis, as measured by calendar-year returns of the Russell 1000 Growth and Value indices. We believe the enthusiasm has gotten out of hand: The growth universe recently traded at 21 times forward earnings per share, while value earned a multiple of just 14. The earnings outlook over the next two years favors growth, but this disparity ranks in the 90th percentile of relative valuation for the two groups over the last 25 years, exceeded only by the high-water mark during the tech bubble of the last century.
The innovation of big tech companies is to be admired, but we believe their share prices, as well as those of the broader growth universe, are at risk on several fronts. Their premium valuation is vulnerable to shocks to the global economy, rising regulatory pressure, and the dynamics of interest rates. But given the valuation gap, cracks in the foundation of growth could set up a welcome and well-deserved recovery for value stocks.
The higher valuation of growth stocks would suggest that their earnings growth has outpaced the value universe, and while some tech leaders have shown extraordinary results, in the aggregate the advantage has in fact gone to value. Since 2009, growth stocks in the Russell 1000 universe have pushed through annual average EPS growth of 8.5%, below the 9.9% growth of value stocks. Granted, that is in part due to the sharper earnings recovery of value stocks out of the great recession, but value stocks also have provided superior dividend yields and earned a total “fundamental return”—growth in EPS plus dividend yield—of 11.5% versus 9.8% for growth stocks.
In the case of value, index returns have lagged fundamental returns (making the group relatively cheaper). For growth, on the other hand, index returns have far outpaced the fundamentals, indicated by the widening discrepancy in valuation between the two styles. Much can be attributed to the overlay of low interest rates prevailing since the financial crisis 10 years ago, and their effect on the math of valuation.
Disruption for the disruptors
Investors’ enthusiasm for the big tech leaders—the FAANG stocks—is understandable. Building on the evolution of the Internet, their growth in their initial markets and innovation into new ones have been astounding, and in a short time established them as some of the largest and richest companies in the world.
But what does the future hold for Amazon or Netflix? The simple math of economic growth suggests that their growth can’t go on forever at the current pace. As Grant’s Interest Rate Observer noted in its September 20 issue, on the current valuation of the large growth stocks, investors seem to infer that their results for next 10 years will have to be as good, or better, than those of the last 10. Sustaining such rapid growth would require new waves of innovation and expansion to new industries, and a global customer base willing and able to buy in. All that is possible, but history convincingly suggests that few companies manage to defy economic gravity and old age with new businesses, much less all of the current favorites.
Aside from the natural tendency of growth to slow, several other forces—some endogenous to tech, others environmental—could knock big tech companies off the top rung of dominance in the market. The first is the attraction of old-school competition from companies outside the big tech boundaries adopting new technologies: In the case of Netflix, for instance, Disney, Comcast, and others are coming to market with video services. In e-commerce, Walmart and Target are martialing their forces to compete with Amazon.
Second is the increased regulatory scrutiny on big tech: Senior executives are appearing frequently in front of the U.S. Congress; European lawmakers have raised the bar on antitrust considerations and prodded companies to pay more taxes; and some Asian nations have restricted companies’ trading in their markets. The U.S.-China trade war could also trim revenue and profit growth as companies are forced to reconfigure their manufacturing and supply chains.
Third, and less likely but still worth recognizing, is that the group is also vulnerable to a surge in global growth, or at least a jump in inflation, which would raise the level of interest rates and in turn reduce the future value of their expected cash flows. Moreover, higher inflation would increase revenue and earnings growth across the board, which should provide a larger benefit to value stocks.
The effects of rising interest rates should not be underestimated. The yield on the 10-year Treasury note currently stands at about 1.8%, and while it has edged above 3% for only a few days since 2012, it was not that long ago that 10-year yields of 4% and higher were prevalent. While a lower discount rate has benefited the valuation of all stocks, it favors the growth universe more so, as its share valuations gain from a longer duration, due to back-loaded and rapidly growing expected cash flows.
The effects of any of these outcomes on big tech share prices could be amplified because these stocks constitute a “crowded trade.” Despite the massive popularity of investing through indexes, people are still adding ETFs which hold those stocks with the best recent returns—amplifying the focus on technology. And there aren’t as many active value investors as there were 10 years ago, leading to a market where value stocks are underrepresented, and more-expensive tech stocks make up a larger share of the indexes.
A return to value
One logical destination for this equity capital would be value stocks. However, it’s not sufficient to simply declare that because valuations are so far out of whack, a significant mean reversion must occur.
But value stocks may provide a catalyst through their own inherent appeal: Their fundamentals have been reasonably strong, and consensus forecasts of EPS growth for the Russell 1000 Value call for a rise of about 6% in 2020, and 9% in 2021 (although versus comparable increases of about 9% and 14% for Russell 1000 Growth). And, to return to our initial point, in the event of a stumble in the current tech-enthused market, the low relative valuations of value stocks should be a haven for investors seeking favorable equity exposures.
That’s a comeback in the making.
This material includes forward looking statements based on Scharf Investments’ experience and expectations about the securities markets and the methods by which Scharf Investments expects to invest in those markets. Those statements are sometimes indicated by words such as “expects,” “believes,” “seeks,” “may,” “intends,” “attempts,” “will,” and similar expressions. The forward looking statements are not guarantees of future performance and are subject to many risks, uncertainties and assumptions that are difficult to predict. Therefore actual investment returns could differ materially and adversely from those expressed or implied in any forward looking statements.